Economics, public policy, monetary policy, financial regulation, with a New Zealand perspective

On macroeconomic policy options

There have been a couple of odd comments this week about the use of macroeconomic policy tools in New Zealand.

In his weekly column yesterday, Brian Fallow suggested that it had been unwise to have put so much emphasis on getting the budget back to balance, and that it was time for more fiscal stimulus. Of course, there is nothing sacrosanct about getting back to balance by any particular date, but if anything I thought our government had been rather too slow to get there. With the benefit of record – and probably unsustainable – terms of trade – there wasn’t really much excuse for having run deficits in the last few years. And a tighter stance of fiscal policy should, at the margin, have eased the upward pressure on demand, the OCR, and the exchange rate.

Fallow draws on the generalised advice of the IMF to advanced economies. But most of those advanced countries can’t do anything much with conventional monetary policy even if they wanted to. Quite a few advanced countries (including the euro area) already have negative policy interest rates, and many of the others – US, UK, and Japan among them – are essentially at zero. Perhaps new rounds of QE might make some difference – I rather doubt they could do much – but to all intents and purposes monetary policy options are exhausted. That is partly the fault of central banks and finance ministries that have done nothing material over eight years to remove the near-zero lower bound on nominal interest rates but, choice or not, it is the situation today.

If there is still excess capacity in many of those countries, and if many of them face widening output gaps if world activity growth continues to slow, the appeal of looking to fiscal policy for stimulus is understandable. In general, I’m not sure it is a call that should be heeded to any great extent, as most of the larger countries already have rather sick fiscal positions – made considerably worse when those countries resorted to fiscal stimulus, to loud cheering from the IMF, in 2008/09.

New Zealand – and some other advanced countries such as Sweden, Finland, Estonia, Australia, and Switzerland – is in the fortunate position of having a low level of public debt. That means we do have some room to use fiscal policy if such stimulus is required. But even that potential isn’t limitless. Faced with another severe recession, even allowing the automatic stabilisers to work would add materially to the government’s debt over several years. In such a downturn, it is probable that the government’s speculative investment vehicle – the New Zealand Superannuation Fund – would lose a lot of money. And for those who worry about the financial stability risks of the house prices more than I think warranted, bear in mind the potential need to bail out banks and their creditors. If there is a severe downturn, we need the political room to allow those buffers to work, not to have to resort to pro-cylical fiscal policy

Fallow – and many international commentators – have favoured additional government spending because interest rates are low. But remember that interest rates are low for a reason – it isn’t just some number thrown up by a random number generator. I’ve argued previously that the effective cost of capital the government should be using in deciding on even good quality projects is probably in excess of 10 per cent (the sort of standard private businesses use), not something close to the government bond rate. And all this is before the questions that must be asked about the poor quality of too much government spending.

There are distinct political limits to how much fiscal stimulus any government can do, even in a crisis. Why fritter away that potential now, when our OCR is still 2.75 per cent? New Zealand has far more monetary policy headroom still open to it than most other countries do. There are real macroeconomic issues in New Zealand – as Fallow points out, the high and rising unemployment rate suggests that the economy continues to run below capacity – but as Eric Crampton noted in his response to Fallow yesterday, it is not as if monetary policy has been tried and failed. Rather, because of the repeated mistaken calls by the Reserve Bank, monetary policy has barely been tried.

ANZ advocated fiscal stimulus back in July. I set out here the reasons why I thought that was the wrong call. I don’t think I’d resile today from anything in that piece.

But the other odd comment on New Zealand macroeconomic policy came from someone who really should have known better. In his speech on Wednesday, the Governor of the Reserve Bank

It is important also to consider whether borrowing costs are constraining investment, and the need to have sufficient capacity to cut interest rates if the global economy slows significantly.

I’ll largely ignore the first part of the sentence (although if inflation is low and unemployment still high, isn’t more private sector investment generally likely to be a good thing?). It was the second half of the sentence that really reads oddly – and arguably, worse than oddly.

This idea of keeping some powder dry in case there is a renewed sharp slowdown pops up from time to time in international commentary. We’ve even seen the argument made that the Federal Reserve should raise interest rates now so that it has room to cut them if there is a future slowdown. But it is a deeply flawed argument. It may have some merit on the fiscal side – higher public debt now leaves less room to run up more debt later on – but in respect of monetary policy it is just wrong.

Monetary policy that is tighter than strictly necessary (in terms of the PTA) now, is likely to both weaken the economy (relative to the counterfactual) over the coming 12-18 months, and further low inflation and inflation expectations. Lower inflation is undesirable (in terms of the PTA itself) and low inflation expectations are deeply problematic. Lower inflation expectations, all else equal, raise real interest rates for any given nominal interest rate. The experience of advanced world since 2007 says that one of the biggest macro management problems of a sharp slowdown in the presence of low inflation is getting real interest rates low enough. It was easy to get real interest rates materially negative in the high inflation 1980s but it is almost impossible to do so now. In other words, holding up nominal interest rates now increases, perhaps materially, how much one might need to cut rates if a severe downturn happens, while doing nothing to create that extra space.

The Governor has rather reluctantly come to acknowledge that global deflationary risks. The last thing anyone in his position should be doing right now is making choices that would make it harder to handle the next sharp slowdown. But that is what he appears to be set to do.

If anything, those countries that still have monetary policy room to move should be doing so now. Real interest rates should be as low as possible, consistent with the PTA – and perhaps especially in a country that starts with the highest real interest rates in the advanced world. Rather than core inflation of 1.5 per cent or less, the Governor should be rather more comfortable with core inflation around 2.5 per cent. The best way to get that sort of outcome would be to have cut the OCR over the last couple of years, not raised it.

As a commenter here the other day put it, this idea that we should hold the OCR up now so that it can be cut later “is like keeping your shoe laces tied so tightly that it cuts off your circulation, just so it feels good to loosen your laces later.”

Between the failure to do anything about the zero lower bound – which the Governor now (belatedly) implicitly acknowledges to be an issue – or, absent that, to consider a higher inflation target, the Governor and the Minister have left New Zealand less well placed than it could have been if there is a new sharp global slowdown in the next few years. But the decisions that keep on delivering such unnecessarily low rates of core inflation (and high unemployment) are those of the Governor alone.

Plenty of market economists have commented on yesterday’s inflation numbers. My only contribution is a simple chart of a new series Statistics New Zealand has just started publishing.

Non-tradables inflation has long been the focus for analysis of the underlying inflation position. Tradables inflation is thrown around by short-term swings in international oil prices and level shifts in the exchange rate, and non-tradables inflation should provide a better guide to underlying inflationary pressures. But non-tradables inflation is made harder to read because of repeated tax increases (notably tobacco taxes) and changes in government charges – which don’t reflect anything about the state of the domestic economy. It is quite common internationally for statistical agencies to publish series excluding taxes and government charges. And now SNZ has provided us with this series for New Zealand. It has the advantage, over the Bank’s sectoral core factor model measure, that it is not prone to revisions.

Note that this measure of non-tradables inflation is running at only 1.6 per cent, barely above recessionary low. Non-tradables inflation should be expected to run above tradables inflation on average over time (there is typically more scope for productivity gains in tradables than in many non-tradables). Indeed, if CPI inflation was going to average around 2 per cent – the Bank’s target – non-tradables inflation shoiuld probably average somewhere in the 2.5-3 per cent range (and perhaps tradables might be in the 1-1.5 per cent range). Non-tradables inflation is extremely low in New Zealand – it is too low and should, as a matter of active policy, be raised.

No doubt the Governor and his economists will say that that is what they have been trying to do. But if so, they have repeatedly failed. Becoming reluctant to cut the OCR further because of the housing market (one of the channels through which lower interest rates work – a buoyant housing market is a desired feature not a bug) or for fear of hitting zero in a global downturn is a recipe for continuing the mistakes of the last few years.

To repeat Eric Crampton’s line: monetary policy has scarcely been tried. It should be.

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10 thoughts on “On macroeconomic policy options”

Are you advocating a lower OCR or something more? If it is just the ORC, will it really make much difference, ie will it lower the yield curve of private borrowers/lenders? I know you have done quite a bit of work in the past on what has caused NZ’s relatively high term rates and I don’t recall that the OCR was a big part of the story. In any case, weak corporate and household demand for debt funding may well reflect prudence in the face of uncertainty about the future. Attempting to bring forward consumption/investment in the face of this uncertainty could well be bad engineering.

I think the case for a materially lower OCR is pretty strong. Yes, I think it would spill over into private yield curves, but perhaps the biggest impact would be through a lower exchange rate – which would make quite a lot of new tradables sector investment attractive.

You are right that I don’t think the OCR or domestic monetary policy can explain why over 25 years NZ interest rates have been so much higher than those in the rest of the world, but that doesn’t mean monetary policy mistakes can’t be made that should be corrected. In the current circumstances, perhaps 1.75% would be a better OCR than 2.75%, but that would still leave our interest rates well above those in most of the rest of the advanced world – and responsibility for that required interest rate would not rest with the RB.

Your final point is perhaps where some of the debate rests. But I’d argue that the RB’s job is to carry out the PTA. If society collectively is content with such low inflation rates then it is up to the MOF to change the PTA, and the inflation target. Personally, I think the “uncertainty about the future” point is overdone – or rather it is important, but it is almost always important. We aren’t in the sort of extreme uncertainty environment of say late 2008. To me, the unemployment rate is a useful benchmark (tho not a foolproof rule): when NZ’s unemployment rate has been persistently high for 6-7 years, and is rising again, and at the same time all measures of goods and services inflation are very low, and credit growth is modest, it is a pretty good basis for keeping on cutting the OCR. I spent too much time earlier in my career helping to get inflation down to believe that “inflation is dead”, but it has been quiescent enough for long enough that I think the Bank should be more accommodating of rather faster growth until there is clear and hard evidence that inflation has actually picked up materially and sustainably (ie more than a one -off shift in the level of prices on the back of a lower exch rate).

Michael, I fully agree with your comments about increased government spending on vanity projects (although you diplomatically didn’t use that exact phrase) but I think it is important to clarify what running a fiscal deficit is and how it can created. The fiscal deficit is the difference between government spending and government income from taxation.

There are two ways to create a fiscal deficit – more spending or less taxing. The effects of the two are quite different; more spending is usually largely wasted (overly bureaucratic processes?) but tax reductions are applied by individuals according to their individual choices. You seem to be ignoring the beauty of the latter. Tax reductions are not only applied individually as best fits each person’s situation (paying off debt, saving or spending as appropriate) but they are also self correcting as wages rise and people move into higher tax brackets over time.

Two other aspects are more political in nature, tax reduction tends to have a longer time lag of 12 to 18 months than spending (6 to 12 months). So from a political timetable viepoint, budget one should be tight, budget two should be tax reduction, and budget three should be more spending.

Yes, I guess I didn’t focus on tax cuts as there is good reason to avoid variability in tax rates (and the sort of stimulus people are now talking about is inevitably temporary) and the related signals to people thinking of working and investing. Yes, fiscal drag can make up the revenue losses over time, but at current inflation (and wage inflation) rates that is a pretty slow process.

If one is serious about using fiscal policy to directly boost demand in the near-term (as distinct from long-term potential growth considerations) I think most economists would say that direct government purchases of goods and services is most likely to be effective (hence the constant talk of “shovel-ready projects” – which, of course, never are.

Personally, I would rather the govt focused energies on reducing the longer-term tax rate on capital income, than on toying with short-term fiscal stimulus. Of course, everything this govt has done has gone in the opposite direction – the 2010 tax package raised the effective tax rate on capital income, the new “brightline” test does the same, and the global BEPS package which NZ is part of (and which I haven’t looked into deeply) seems set to do the same. It isn’t the main reason why investment is pretty weak, but it doesn’t help.

“Reducing the longer-term tax rate on capital income” sounds good to me. My main point was that you seemed to be ignoring the rich seam of selective tax reduction in favour of the sugar rush of spending. Why is tax reduction seen as “benefiting the rich” rather than stimulating employment?

Current monetary and fiscal policy seem to me to be misguided. If I want to drive at 50 kph I keep my foot off the brake and my foot on the gas until I reach the required speed. Then I gently ease off the gas. We seem to have done this but at 42kph not 50 kph if the unemployment rate is anything to go by.

Fair comment. I like the 42km line – altho I imagine the RB will claim they have the foot almost flat to the floor (since they still claim the “neutral” interest rate is 4.5%, and the Governor keeps claiming that monetary policy is more accommodative (globally) that ever in history.

The fiscal advice you propose is consistent with mainstream new-Keynesian models. This is the sort of outcome you get from the IMF modeling of the impact of a tighter fiscal stance in NZ in 2010 WP 10/128.

However, all these models assume that central bank acts rapidly and forcefully and is able to return inflation to target and output back to potential in short order (12-18 months or quicker because they assume that the monetary policy maker has a model of the economy that tell it in advance where output will be with certainty). This has not been the case. It is now 6 years since inflation has been at target and output at potential.

In these circumstance loser fiscal policy in the past (all else being equal) would have lead to high output, lower unemployment and inflation closer to target. All around welfare is higher. Perhaps we should leave aside the issue of what the fiscal policy maker should do if they share your beliefs about the RBNZ meeting its future target. Although just for the sake of playing devils advocate it would seem to me to be hard for the central bank to react to a fiscal loosening in this situation in the same way they might at close to full employment and their inflation objective.

Just looking at the near term it appears to me we face the risk of fiscal policy again being contractionary (perhaps only mildly) at a time when output is below potential – and fiscal policy will again be pro-cyclical.

Now there might be a good reason for all this if NZ was struggling with a large public debt burden and had no history of delivering fiscal consolidation. Yet this is not the case on either count. If you look at the IMF fiscal number and look at the change in primary balance (I used a 3 year average over the crisis period compared with calendar 2015) you will find that NZ adjustment (~ 7.5) looks like around the level of Portugal and Spain and Greece (Ireland is off the chart because of the size of the fiscal support provided to the banks through the accounts in these years). This is all in the context of macro models that suggest the appropriate pace of debt reduction from once in a generation shock is slow…..

And what about commodity prices. I think the way to think about this is that you might tell you something about the right level of structural balance to aim for abstracting from the cycle. In my humble opinion it cannot tell you too much about the right fiscal stance from a cyclical point of view. To see this just imagine that this approach would have suggested a rapid tightening of the fiscal stance in 2010 as commodity prices returns to their peak despite the economy being in a deep slump. Another way to see this is to look at the cyclically adjusted balance scenario with the terms of trade at their 30 year average – this suggests that the structural balance is 2.5 percent worse than the forecast in every year.

Lastly, the decision needs to be made under the know that the outcomes are asymmetric. If the central bank does its job as the macro models predict then we get a slightly different mix of output. But output reaches potential – no harm no foul. On the other hand if this is not the case then the outcome of looser policy will be much like I describe above for the past 5 years – higher output, employment, and welfare. All without reference to the risks of deflation or the zero lower bound.

Thanks. Such substantive comments probably warrant a response in a separate post, but for now just note that in my original post I carefully used a “should” in describing the impact of a tighter fiscal stance.

“a tighter stance of fiscal policy should, at the margin, have eased the upward pressure on demand, the OCR, and the exchange rate.”

Since the Bank has been running off forecasts – flawed as they have been – , including not inaccurate forecasts of the fiscal policy, tighter fiscal policy probably did affect monetary policy. In that sense, only a loosening of fiscal policy that the Bank didn’t recognise might have delivered higher output and inflation.

“Since the Bank has been running off forecasts” – therein may lie the problem. In a former life in manufacturing we had this problem – the inventory problem. Basically if you are running off forecasts you will always have too much or too little stock. The solution is to focus on flexibility, adopt just in time systems with small batch sizes, reduce change over times and obsessively focus on the small defects that really mess things up. The response time to new information (in our case order flow) must be reduced.

Not sure of the exact analogues in monetary and fiscal policy but I do recall the RBA put up a paper a couple of years back that looked at this issue with housing supply.